After years of having no statutory or regulatory authority on the issue and IRS anti-taxpayer guidance that was inconsistent with regulations governing the calculation of the amount of the allowable charitable income tax deduction for contributions to a “net income” charitable remainder unitrust, Section 344 of the Protecting Americans from Tax Hikes Act of 2015 (“PATH”), signed by the President on December 18, 2015, amends IRC § 664(e) to level the playing field in valuing the charitable remainder interest in the case of an early termination of net income charitable remainder unitrusts with no make-up provision (“NICRUTs”) and net income charitable remainder unitrusts with a make-up provision (“NIMCRUTs”).[1]

Under the amendment made by PATH, consistent with calculating the value of the charitable remainder interest in determining the amount of the available charitable income tax when funding a NICRUT or NIMCRUT, the net income limitation will now similarly be disregarded in determining the value of the charitable remainder interest in the case of an early termination of a NICRUT or NIMCRUT. In light of today’s record-low interest rate environment, this change has the potential effect of drastically increasing the amount of the distribution to the non-charitable beneficiaries upon the early termination of a NICRUT or NIMCRUT or, if the interest of the non-charitable beneficiaries is given to charity, the amount of the income tax deduction for that. The change brought about the Section 344 of PATH has been long-sought by tax practitioners and potentially offers a much greater payout to non-charitable beneficiaries in the event of an early termination if a NICRUT or NIMCRUT. Prior to Section 344 of PATH, the Internal Revenue Code did not provide a rule for valuing the interests in a charitable remainder trust with a net-income limitation in the event of an early termination of the trust.

Background on Charitable Remainder Trusts

A charitable remainder trust (“CRT”) is defined in Section 664 as one that provides for (1) an annuity (a fixed sum of money) to be paid each year, known as a charitable remainder annuity trust or “CRAT,” or (2) a unitrust amount, which is the amount determined annually by multiplying the fixed percentage (the “unitrust percentage”) set forth in the trust instrument times the annual value of the trust ) or “CRUT,” to be paid each year, known as a charitable unitrust or “CRUT,” to a non-charitable taxpayer (e.g. an individual) for a time (fixed number of years not in excess of 20 or for the life or lives of the beneficiaries) when it terminates and then passes to or for charity. The annuity must be at least five percent (5%) of the tax value of the assets when contributed to the trust and the unitrust percentage must also be least five percent (5%). (Other “actuarial” requirements or limitations also apply.)

However, the governing instrument of a CRUT may limit annual payments to the lesser of the computed unitrust amount (equal to the specified percentage multiplied by the annual fair market value of the trust assets) or the trust’s fiduciary account income (FAI) as defined in Section 643(b). Such a “net income” CRUT may but is not required to provide for the excess of the unitrust amounts computed over the FAI earned in the trust to be distributed if and when the FAI exceeds the unitrust amount for the year. In other words, the trust may permit a make-up the shortfall of the unitrust amounts over FAI. If the trust does not provide for the make-up, it is known as a net income CRUT or “NICRUT”. If it does provide for the make-up, it is known as a net income with makeup CRUT or “NIMCRUT.”

A taxpayer who during lifetime creates a “qualifying” CRT (that is one that meets the criteria of Section 664) is entitled to a gift tax deduction for the value committed to charity in the trust, which must be at least ten percent (10%) when the trust is created or any additional contribution (permitted only for CRUTs that authorize additional contributions) is made, The estate of a taxpayer who creates one at death is entitled to an estate tax deduction for the value of the charitable remainder interest. In addition, a taxpayer who during lifetime creates such a trust may also be entitled to an income tax deduction for the value of the charitable remainder interest.

A key factor, therefore, is the calculation for tax purposes of the charitable remainder. The principles used in making the calculation are set forth in Section 7520. For gift, estate tax and income tax purposes, the calculation is the same for a CRUT and for a net income CRUT. For charitable income tax deduction purposes, it is assumed, therefore, that notwithstanding the net income limitation, the non-charitable unitrust beneficiary will receive the entire amount of the unitrust payments as though the NICRUT or NIMCRUT were a standard CRUT. This may also limit the charitable income tax deduction if the unitrust recipient contributes his or her net income unitrust interest to charity because the value of the contributed interest will be based, not on the unitrust payout percentage, but the rate published by the IRS to determine the value of a fiduciary income interest.

Valuing the Charitable Remainder Trust of a NIMCRUT OR NICRUT Upon Early Termination

Because transactions involving a CRT are subject to the self-dealing rules of Section 4941, IRS rulings have indicated that when a CRT is terminated early, the charitable remainder beneficiaries must receive the actuarial present value of their remainder interests, with the remaining funds paid out to the non-charitable beneficiaries of the trust holding the term interests. See, e.g., Ltr. Ruls. 200208039, 200912036, and 201325018 (not precedent). Otherwise, an act of self-dealing under Section 4941 will be considered to have occurred. See, e.g., Ltr. Rul. 200252092.

Valuation Approach Used by the IRS Before PATH

Prior to the enactment of Section 344 of PATH, there was no statutory or regulatory authority on the effect of a net-income limitation on valuing the term and remainder interests in a NICRUT or NIMCRUT upon their early termination, although there were a number of private letter rulings addressing this issue in the context of a NIMCRUT, which were equally applicable to a NICRUT. Ltr. Ruls. 201325018 - 201325021, 200733014, 200725044, and 200833012.[2]

The IRS rulings provide that the appropriate calculation of the actuarial value of non-charitable interests in a NIMCRUT must take into account the net income provisions, so as to ensure that there is no a greater allocation of assets to the non-charitable beneficiaries. These rulings, therefore, required the use of a “reasonable method” for the calculation that does not inappropriately inflate the value of non-charitable interests to the detriment of the charitable remainder beneficiary. The rulings stated that “one reasonable method to calculate the actuarial value of the income and remainder interests” upon the early termination of a NIMCRUT is to use the lesser of the stated percentage distribution rate of the NIMCRUT or the Section 7520 rate in effect for the month of termination, with the Section 7520 rate representing the deemed rate of fiduciary accounting income to be earned by the trust.

Using this approach in the current near-record low Section 7520 rate environment (e.g., 2% for December 2015) has the effect of dramatically reducing the value of the noncharitable “lead interest” in a NIMCRUT and NICRUT, thereby resulting in a much lesser distribution to the non-charitable beneficiary upon an early termination (or a smaller charitable deduction if the lead interest is contributed to charity) than if the net income limitation were not considered.

In Ltr. Rul. 201325021 (not precedent), for example, the distribution of funds to the non-charitable beneficiaries upon the early termination of a NIMCRUT, which was to occur in either March or April 2013, was based on the Section 7520 rate of 1.40% in effect for those months, substantially less than the unitrust payout percentage provided under the trust. The IRS ruled favorably on the Section 4941 self-dealing issue, stating that as a result of this methodology, “the income beneficiaries are not expected to receive more than they would during the full term of Trust under the above-described methodology for valuing their interests in a charitable remainder trust with a net income make-up feature.”

The IRS ruling's approach to valuing the non-charitable term interest upon the early termination of a NIMCRUT directly contrasts with the valuation method required under applicable Treasury regulations for computing the charitable income tax deduction upon the creation of a NIMCRUT (or a NICRUT), as indicated above.

The IRS has been taking an inconsistent approach in this matter. For charitable income tax purposes, the IRS assumes that, regardless of the net income limitation, the non-charitable beneficiary of a NIMCRUT or NICRUT will receive the full amount of the payments based on the stated unitrust payout percentage, thereby minimizing the charitable deduction. For self-dealing purposes, however, it assumes that only the fiduciary accounting net income (based on the Section 7520 rate in the month of termination) will be paid to the non-charitable beneficiary, thereby minimizing the payout to the non-charitable beneficiary (or reducing the charitable deduction if the unitrust interest is contributed to charity).

Valuation Approach Under PATH

(1) by adding at the end the following: ‘‘In the case of the early termination of a trust which is a charitable remainder unitrust by reason of subsection (d)(3), the valuation of interests in such trust for purposes of this section shall be made under rules similar to the rules of the preceding sentence.’’, and

(2) by striking ‘‘FOR PURPOSES OF CHARITABLE CONTRIBUTION’’ in the heading thereof and inserting ‘‘OF INTERESTS’’.

(b) EFFECTIVE DATE.—The amendment made by this section shall apply to terminations of trusts occurring after the date of the enactment of this Act.”

Under this provision, in the case of an early termination of a NICRUT or NIMCRUT, the remainder interest is valued using rules similar to the rules for valuing the remainder interest of a charitable remainder trust when determining the amount of the grantor’s charitable contribution deduction for contributions to the trust. Contrary to the multitude of IRS letter rulings, therefore, the remainder interest is computed without regard to any net income limitation.

Therefore, the present value of the non-charitable and charitable remainder interests upon the early termination of a NICRUT or NIMCRUT is made on the basis of the stated unitrust percentage otherwise required to be distributed to the non-charitable beneficiaries, and the net-income limitation contained in such trusts is disregarded. In light of today’s record-low interest rate environment, this change has the potential effect of drastically increasing the amount of the distribution to the non-charitable beneficiaries upon the early termination of a NICRUT or NIMCRUT (or the amount allowed as an income tax charitable deduction if the unitrust interest is contributed to charity).

Conclusion

Section 344 PATH is welcome news in that the rule disregarding the net-income limitation of a NICRUT or NIMCRUT in determining the amount of the available charitable income tax deduction now applies to the determination of the values of the non-charitable and charitable remainder interests upon the early termination of a NICRUT or NIMCRUT. Consistency in the treatment of taxpayers upon the funding of a NICRUT or NIMCRUT and upon their termination has now been achieved, as had been long sought. In light of today’s record-low interest rate environment, this change has the potential effect of drastically increasing the amount of the distribution to the non-charitable beneficiaries upon the early termination of a NICRUT or NIMCRUT (or increasing the amount of the charitable deduction allowed by the contribution by the unitrust recipient to charity).

Although using the PATH method to value the unitrust interest in a NIMCRUT or NICRUT eliminates any problems under Federal tax law, it may be that the attorney general of the state involved (as the statutory representative of charity) or a court having jurisdiction over the trust would have to approve the early termination of the trust and it is possible either would not agree to using the PATH valuation methodology.

[1] References hereinafter to either “IRC §” or “Section” refer to the applicable section of the Internal Revenue Code of 1986, as amended.

[2] Before issuing these rulings, the IRS had issued a number of rulings in the context of an early termination of a CRUT where the valuation of the term interest of a non-charitable beneficiary of a CRUT having a net-income limitation was determined without regard to such limitation. See, e.g., Ltr. Ruls. 200208039, 200304025, 200525014 (not precedent).